Overview of Accounting Part 1 Click here for Streaming Audio To Accompany Presentation (optional)

1. Overview of AccountingPart 1Click here for Streaming Audio To Accompany Presentation (optional) EGR 403 Capital Allocation Theory Dr. Phillip R. Rosenkrantz Industrial & Manufacturing Engineering Department Cal Poly Pomona

2. EGR 403 - The Big Picture • Framework:Accounting& Breakeven Analysis • “Time-value of money” concepts - Ch. 3, 4 • Analysis methods • Ch. 5 - Present Worth • Ch. 6 - Annual Worth • Ch. 7, 8 - Rate of Return (incremental analysis) • Ch. 9 - Benefit Cost Ratio & other techniques • Refining the analysis • Ch. 10, 11 - Depreciation & Taxes • Ch. 12 - Replacement Analysis EGR 403 - Cal Poly Pomona - SA1

3. Introduction • Engineers need to understand accounting to fully understand the language of middle and upper management • Performance evaluations of engineers often based on accounting data (e.g., budgeting) • It is difficult to interpret information and find accounting mistakes without some accounting background EGR 403 - Cal Poly Pomona - SA1

4. Introduction (cont’d) • Accounting courses for engineers: IME 239 or take courses in an MBA program • Engineering projects are undertaken based largely on their ability to generate “Profit”. Profit is an accounting term. • Profit = Revenue - Expenses • Revenue (money in) is a.k.a. “income” or “sales” • Expenses (money out) are a.k.a. “costs” EGR 403 - Cal Poly Pomona - SA1

5. Introduction (cont’d) • Manufacturing is cost driven • Products/processes designed to use least $$ • Manufacturing costs need to be controlled • “Continuous Improvement” programs reduce cost • Intangible considerations are also important • Resources & Capabilities • Strategy • EGR 403 will concentrate on the financial aspects of economic decision making. EGR 403 - Cal Poly Pomona - SA1

6. Financial Statements • Balance Sheet (General Accounting) • Snap shot of what the company owns and how much they owe. Discloses information to investors. • Income Statement (Cost Accounting) • Shows profit for the period based on Generally Accepted Accounting Practices (GAAP) • Cash Flow Statement (Sources & Uses of Funds) • Shows the actual need for cash over time so that the company can manage their cash properly • The first two statements will be discussed EGR 403 - Cal Poly Pomona - SA1

7. Accounting Concepts • Cigar Box Accounting Method - Revenue goes into the cigar box. Expenses go out. What is left is your “profit”. • Accrual Accounting - Expenses are matched with revenue so that profit reflects actual activity and expenses in the time period. The matching principle is necessary for taxation and reporting performance. EGR 403 - Cal Poly Pomona - SA1

8. Costs & Depreciation • Costs fall into two categories: • Expenses - useful life of less than one year • Fixed - do not vary (e.g., lease costs, rent, insurance) • Variable - vary with volume of production (e.g., labor, materials, supplies, rent, etc.) Cost of Good Sold = COGS. • Capital Expenditures - $ spend on improvements or additions with useful life greater than one year (e.g., machinery, buildings, furniture, etc.). • Depreciation - allocation of the cost of capital expenditures so that revenue is matched with expenses for items that will last more than one year (Land is not depreciable). EGR 403 - Cal Poly Pomona - SA1

9. Depreciation Example • You purchase a $50,000 CNC machine. Useful life = 5 years. Salvage value = 0. • If you deduct the entire $50K as an expense the first year, you are not matching the revenue since there are 4 years of life left. • Straight line depreciation = $50,000/5 years = $10,000/year. • Depreciation expense = $10,000/year for 5 years. This matches revenue with expenses. EGR 403 - Cal Poly Pomona - SA1

10. Income (total revenue) Expenses Fixed Costs COGS (Variable) Depreciation Total Expenses Gross Profit (Income - Expenses) State & Federal Taxes (~40%) Net Profit (“Bottom Line”) $100K $25K $50K $10K -$85K $15K -$ 6K $ 9K Profit & Loss Statement(a.k.a. “P & L”, or Income Statement) EGR 403 - Cal Poly Pomona - SA1

11. What Happens to Net Profit? • “Dividends” are paid to owners (share holders) as part of their return for investing in the business. Their money is at risk. • Example: $9K Net Profit • $3K to dividends (1/3 used here as example) • $6K retained in the business • Dividends are considered “personal income” for shareholders and therefore taxed again (double taxation). So the majority of corporate profits go to taxes. (note to those listening to narrative: go to slide 12 when retained earnings are mentioned) EGR 403 - Cal Poly Pomona - SA1

12. What Happens to Net Profit? (cont’d) What can the company do with the remaining $6K? This is “capital allocation” • “Retained Earnings” - invest in facilities & equipment • Retire debt (pay off loans, retire bonds) • Profit sharing, bonuses, indirect benefits • Research & development • Permanent raises or other increased benefits • Help the community (donations, scholarships, etc.) • Buy back stock EGR 403 - Cal Poly Pomona - SA1

13. “The Bottom Line” • Profits were traditionally shown on the books using black ink. A company showing a profit is sometimes said to be “in the black.” • Losses (negative profits) were traditionally shown on the books using red ink. A company showing a loss is sometimes said to be “in the red.” EGR 403 - Cal Poly Pomona - SA1